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Best Practices in Defined-Benefit Plan Management

Companies must balance a host of disparate, and sometimes competing, pressures in managing their pension plans.

According to the Pension Benefit Guaranty Corporation (PBGC), there are more than 25,000 corporate pension plans in the United States.1 For each of these plans, managers in the sponsoring company make decisions on a regular basis about how much and how frequently to contribute to the plan and what investment strategy to pursue with plan assets. Until recently, the most common approach to these decisions taken by plan sponsors could be loosely characterized as: Let’s make contributions at the minimum level permitted by regulation, and let’s use a growth-oriented investment approach, trusting that over time the combination of market returns and legislative smoothing will lead the plan to be fully funded at a reasonable—and reasonably stable—cost.

That approach doesn’t necessarily work anymore. The Pension Protection Act of 2006 (PPA) redefined how contributions are calculated, moving in the direction of marked-to-market valuations and also reducing the time period over which funding shortfalls need to be made good. Statement of Financial Accounting Standards SFAS 158 had a similar impact on how pension plans are captured on corporate balance sheets. These changes increased the complexity of managing pension plans’ impact on the sponsor’s financials.

There are several ways in which pension plans impact the corporations that sponsor them: by requiring funding contributions from the sponsoring company, by changing that organization’s income statement and balance sheet as asset and liability values rise and fall, by subjecting the company to costs imposed by the PBGC, and potentially by limiting benefits to both plan participants and corporate executives if a plan’s funded ratio falls below certain thresholds. A company’s funding and investment decisions around its pension plan present a multifaceted challenge. Two seemingly identical plans may have significantly different impacts on their sponsoring organizations as a result of differences in their corporate situation and financial status.

Contribution Decisions: Balancing Costs of Defined Benefits

The high costs and growing risk associated with running a defined-benefit plan have spurred a general trend toward plan closures. Although the majority of plans (59 percent) remain open, many sponsors have chosen to close their plans to new participants or freeze benefits for current plan participants. Thirty-two percent of plans now offer no accrual of benefits at all.2 For a frozen plan that will incur no further benefit accruals, company contributions are required only to the extent that existing assets cannot cover the benefits already promised. Even in this situation, however, contribution decisions are not always straightforward.

Although the PPA represented a legislative shift toward mark-to-market valuation for pension assets and liabilities, and increased the minimum level of contributions for most plan sponsors, the Moving Ahead for Progress in the 21st Century Act (MAP-21) of 2012 was a step in the other direction. MAP-21 was primarily designed to fund highway repairs, but it also reduced the size of contributions that corporations are required to put into their defined-benefit plans. The logic behind this rule change was that if corporations contribute less money to their pension plans, they will claim less tax relief for their pension contributions, which means the federal government will bring in more revenue, ultimately enabling more highway repairs.

There is a catch, though. At the same time that it reduced minimum pension plan contributions, MAP-21 raised the premiums plan sponsors must pay to the PBGC. The variable-rate portion of the premium for companies with underfunded plans is rising from 0.9 percent of the funding shortfall to 1.8 percent by 2015, with further increases beyond that. This means that if a plan is underfunded, every dollar that the company keeps in its corporate account, rather than putting it into the plan, will incur what is in effect a 1.8 percent tax in the form of an increased PBGC premium. Although corporations in general will continue to prefer to hold money in their corporate account rather than their pension plan because doing so gives them greater flexibility, an analysis of net present value under the new rules usually comes out in favor of funding sooner rather than later because of the drag caused by the increased PBGC variable-rate premium.

Individual situations vary, of course. Financing costs and tax considerations are important. The argument in favor of funding early is strongest for a corporation that has access to capital and that would incur an immediate tax benefit from contributing to the plan. The balance sheet composition, plan asset allocation, and the opportunity cost of other uses for corporate cash may also play into the decision.

A typical plan that was 80 percent funded prior to the passage of MAP-21 might have seen that funded status jump to 100 percent using the new calculation basis. That has a big impact on required contributions. Indeed, among the U.S.-listed corporations with the largest pension liabilities, about two-thirds have said that they are not required to make any contributions to their primary U.S. pension plans in 2013, mainly thanks to MAP-21. Nevertheless, most have said they expect to make contributions. In Boeing’s quarterly earnings statement on July 25, 2012, CFO Greg Smith summed up the attitude of many executives: “[MAP-21] certainly does give [us] some flexibility in the years to come, but I don’t see our plan on how we will fund [our pension plan] changing.” Ultimately, the impact of MAP-21 on pension funding may be the opposite of lawmakers’ intention. Despite the lower minimum contribution levels, MAP-21 may push companies to contribute more to their pension plans, if they can afford to do so, in order to save money in the long run.

1. Single employer plans insured by the PBGC as of 2011. Source: PBGC databook.2. Single employer plans insured by the PBGC as of 2011. Source: PBGC databook.

Another important consideration in contribution decisions is the possibility that capital may become trapped in the plan if market conditions become more favorable and the plan’s funded status improves. This is mainly a concern for frozen plans, which are no longer accruing benefits and so cannot use the surplus to offset the cost of future accruals. Withdrawing money from a pension plan can be difficult and tax-inefficient, so possible upswings in asset values should be a factor in contribution decisions.

Once the funded ratio approaches 100 percent, the possibility of trapped capital starts to loom. To manage this risk, funding policy and investment policy need to work in harmony. This is a major reason why liability-responsive asset allocation (LRAA) is growing in popularity. LRAA ties asset allocation to the plan’s funded status. As the plan’s funded status improves, the plan makes less-risky investments. In other words, the plan takes risks only when they would have a useful payoff. If success would simply lead to trapped capital, then a plan has nothing to gain from a risk-oriented investment policy.

Watching the Funded Status Trigger Points

In addition to its role in decisions about contribution levels, a pension plan’s funded status under the PPA requires particular attention when it’s near either 60 or 80 percent. If funded status falls below 80 percent, this means (among other things) that a notice must be sent to members and to the PBGC, that freedom to make lump sum payments may be restricted, that further calculations must be carried out to determine whether the plan is “at risk,” and that benefit improvements may be possible only if they are funded immediately. At a funded status below 60 percent, things become even more serious. Benefit accruals are frozen; no lump sum payments are permitted; and executive non-qualified benefits are restricted, even though those benefits would not be paid from the plan. For plans with a funded status near 60 percent or 80 percent, it makes sense for plan sponsors to seriously consider bumping up contributions to the plan in order to bring the funded status over the threshold.

Since contribution decisions today are often a question of judgment (“How much do we want to contribute?”) rather than formula (“How much does the law require us to contribute?”), contribution policy and investment policy interact in interesting new ways. Each needs to be considered in light of the other, and in light of decisions’ effect on the plan sponsor’s financial statements.

Impact on the Income Statement

A pension expense is part of the plan sponsor’s income statement. The company calculates this expense based on SFAS 873, which was produced more than 25 years ago and is now showing its age. The calculation of the income statement’s pension expense is thorny because it is based on a company’s expected return on plan assets (EROA). In other words, it requires the company to make an assumption about how asset values will change over the long term. In most areas of accounting, a reward that is earned for taking risk is credited only if and when it materializes. In contrast, EROA allows a company to take the credit now for an expected future reward. A higher EROA leads to higher recorded corporate earnings in the current reporting period, even though changing the assumption about pension assets’ value does not generate any real profit for the organization. Obviously, this creates an incentive for a plan sponsor to prefer a higher EROA over a lower one, within reason.

This accounting issue has a real impact on pension plans’ investment policy. Sometimes sound investment policy involves reducing risk, but choosing less-risky assets might reduce the expected return on plan assets that the company uses to calculate earnings. In this environment, companies may find it difficult to change their investment policy to lower their portfolio risk because there may be a misalignment of incentives between the plan and those responsible for choosing the EROA assumption. Companies need to recognize the potential for misalignment of incentives and take steps to preclude it from leading to inappropriate investment decisions.

Meanwhile, International Accounting Standard (IAS) 19 recently changed to have plan sponsors fully recognize market fluctuations in the year in which they occur. These fluctuations do not appear in the quarterly or annual profit-and-loss (P&L) statements. Instead, they’re accounted for annually in the Statement of Other Comprehensive Income (OCI). Under this approach, a stable element of investment earnings is treated as interest (and included in the P&L) and the remainder—the fluctuations due to market variation—is treated as an unanticipated gain or loss (and included in OCI). There is a strong possibility that the U.S. standard will move in a similar direction within the next few years.

Pre-empting this possible move, some corporations—most notably AT&T, Verizon, UPS, and Honeywell—have chosen to adopt more mark-to-market approaches in their income statement calculations. This is permitted, although not required, by current U.S. accounting standards. The details of these corporations’ changes vary, as—to some extent—do the rationales given. The general sense that they improve transparency and represent better accounting is captured in an observation by AT&T’s CFO Rick Lindner, in a conference call discussing that company’s change: “The more we looked at different methods, the more complex the amortization and the benefit accounting became, and we finally stepped back from it and said, ‘Let’s go in the opposite direction: Let’s make this simpler.’”

3. SFAS 87 and SFAS 158, which covers balance sheet disclosure, both now form part of Accounting Standards Codification (ASC) 715.

Changes to the Balance Sheet

Compared with its effects on the corporate income statement, a pension plan’s implications for the balance sheet are fairly straightforward. The corporate balance sheet must include a net pension asset (or liability) equal to the current surplus (or deficit) of asset value over liability value in the pension plan. In some unusual situations, the balance sheet calculation can be more complicated—for example, if the plan has a surplus that is too large to offset against future contributions.

Because the pension plan’s value on the balance sheet swings with the market, there is a possibility that it could lead to a breach of debt covenants. A more common concern is the question of how stock analysts will interpret balance-sheet volatility. In general, analysts expect volatility in the net pension asset when asset values or interest rates fluctuate. For most corporations, this need not cause alarm. However, for companies in which the plan’s balance sheet impact is unusually large—for example, if the pension plan is large in relation to the size of the corporation—closer attention needs to be paid. Thus, it is no surprise that many of the corporations taking the lead in reducing risk within their pension plans are those with the largest plans, especially those—such as auto manufacturers and airlines—whose corporate valuations have not grown as fast as those of their plans.

On the flip side, because the calculations behind the balance sheet numbers are marked-to-market, they tend to provide the most objective basis for investment-related activities, such as monthly or quarterly reporting in connection with a liability-driven investing program, and they may serve as the basis for an LRAA glide path.

Using a selective yield curve to calculate the present value of plan liabilities complicates the interpretation and use of the balance sheet numbers. In short, this approach involves choosing a discount rate based on a subset of the bond market rather than the average yield across all high-quality bonds. The bonds in the subset are chosen for their higher yields (an indicator of higher risk), which allows the plan sponsor to disclose a lower liability value. In reality, the plan’s actual investment portfolio may not be able to match the performance of the balance sheet liability. Use of selective yield curves has increased in recent years, but it’s far from universal.

Ongoing Changes in PBGC Costs

The PBGC, which protects pension plan participants in the event of a plan sponsor’s failure, is funded by the premiums plan sponsors pay. Unfortunately, the PBGC is currently in a weak financial position: The latest annual report disclosed a shortfall as of September 30, 2012, amounting to $34 billion. (This calculation uses more conservative assumptions than most corporate plans do, and some industry groups have argued that the PBGC overstates its weakness as it seeks better funding and lower liabilities.) Concerns over the strength of the PBGC translate into greater demands on plan sponsors. In addition to the substantial premium increases introduced by MAP-21, there have been proposals to link a plan sponsor’s premium level to its corporate credit rating, which would further increase pension costs for many organizations.

Plan sponsors have two primary approaches to managing their PBGC-related costs. The first, which we have already described, is to reduce funding shortfalls and hence reduce the size of their variable-rate premium. The second is to reduce the number of plan participants, which would reduce the fixed-rate portion of their premium. This might be done by offering lump sums to terminated vested members in lieu of their pension benefits. Another risk-transfer option is to buy out retiree liabilities with an insurance company, purchasing annuities to transfer responsibility for payment of future pension benefits to the insurance company.

Best Practice: Balancing Diverse Considerations

Clearly, U.S. companies’ decisions about contributions to their pension plans and investment policy for plan assets are complicated by the diverse—and sometimes conflicting—pressures created by the different laws and regulations that govern plan funding, investments, protection, and accounting. Therefore, plan sponsors, pension staff, and investment staff must understand the importance of each of these pressures within the context of their organization’s unique circumstances. Decision-makers need to be able to answer questions such as:

Is our company’s balance sheet a material pressure point?

Is the flexibility to defer contributions offered by MAP-21 useful to our business?

What would our earnings statement look like under a marked-to-market approach?

How does each available choice affect the interests of participants in our plan?

Different organizations have different priorities, and best practices begin with knowing what those priorities are. Knowing where risk lies for your organization and understanding the impact of the ever-changing regulatory environment are critical. Increasingly, these are priorities that are being discussed at the highest levels. The potential impact of a pension plan on the sponsoring corporation is larger today than it has ever been, and many treasurers and CFOs have found themselves learning far more than they ever thought they would need to about the details of pension funding and accounting.

In a complex world, pension plan sponsors and staff must constantly balance an assortment of disparate goals as they manage the plan. Best practices involve making every decision with all of these goals in mind.

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Bob Collieis chief research strategist in Russell Investments’ Americas institutional business. Collie is responsible for the strategic advice delivered to the various parts of Russell’s institutional client base, as well as for working with the manager research team, product groups, and other research efforts across Russell. He is also the lead author of the Fiduciary Matters blog.

David Phillipsis a senior investment strategist in Russell’s Americas Institutional business. Phillips is responsible for strategic allocation and risk analysis for advisory and investment outsourcing clients and prospects.

Gary Stentzis a portfolio manager in Russell’s Americas institutional business. Stentz is responsible for the development of strategic, full-service solutions and overall management of investment outcomes for some of Russell’s largest investment outsourcing clients.

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